The Smith Maneuver allows your mortgage interest payments to be tax deductible, which can then be used to pay off your mortgage faster through higher tax refunds. At the same time, you will borrow money through a home equity line of credit (HELOC) to invest.
How the Smith Maneuver works is based on the deductibility of interest expenses when calculating your income tax. If you borrowed money to invest in capital property that generates income, you can claim the interest that you paid on your tax return. For example, you can claim interest on money that you borrowed to invest in a stock that pays out a dividend. You cannot claim interest if the stock does not pay a dividend.
By turning your mortgage into an ‘investment loan’, you can claim the interest that you pay on your mortgage. This is done by first getting a readvanceable mortgage. Readvanceable mortgages combine a mortgage with a home equity line of credit. As you pay off your mortgage, the credit limit of your HELOC increases, allowing you to borrow more money again as your mortgage is paid off.
You then borrow from your HELOC to invest. Since your HELOC is now an investment loan, you can claim interest that you pay as a deduction against your income. You can then use your extra tax savings to pay your mortgage, which will allow you to borrow even more money from your HELOC to invest.
Let’s say that you go to Scotiabank to get their Scotia Total Equity Plan (STEP). Your home is valued at $800,000, and your mortgage balance is $500,000. The maximum loan-to-value (LTV) for a mortgage and HELOC is 80%. This means that you can borrow up to 80% of the value of your home, or $640,000.
Since your mortgage balance is $500,000, this means that the most that your HELOC’s credit limit can be is $140,000. Your mortgage rate is 2% with 15 years left in its amortization. Your HELOC’s interest rate is 3%. Your annual income is $100,000, which means that your combined marginal tax rate is 43.4%.
|Marginal Tax Rate||43.4%|
You’ve been doing some financial planning and you feel that your risk tolerance is high. You decide to use your HELOC to invest in dividend-paying stocks.
The stocks have a dividend yield of 4%. After one year, your dividend income would be $5,600 (2% of $140,000). Dividend income is taxed favourably compared to interest income due to dividend tax credits. If stock prices rise, you may also be making capital gains.
If you borrow $140,000 and invest for one year, your annual interest expense would be $4,200 (3% of $140,000). Since this is an interest expense for an investment loan, it is tax deductible. Your income tax will be reduced by $1,822 (43.4% of $4,200), which can result in a tax refund.
Your monthly mortgage payment is $3,216. Of this amount, $2,382 goes towards your principal while $833 goes towards your interest. To simplify, let’s say that your mortgage principal payments are tied one-to-one with your HELOC’s credit limit. For example, every $1 paid towards your mortgage principal will increase your HELOC credit limit by $1.
If you make a $3,216 mortgage payment, your HELOC credit limit increases by $2,382. This gradually transforms your mortgage into an investment loan HELOC, as you would repeatedly borrow back money through your HELOC that you have paid into your mortgage.
Your income tax will be reduced by $1,822, which you can then use towards paying your mortgage principal. As you make more and more payments, along with your tax refund and investment earnings, your mortgage will be paid off quicker.
On the other hand, you can also think of the benefit as being able to borrow money at a lower rate that you then use to invest. The tax deduction at a 43.4% marginal tax rate effectively reduces your HELOC’s interest rate from 3% to 1.7%. If you invest the money that you borrowed from a HELOC into a security that earns more than 1.7% per year, you will be making even more money which you can use to pay off your mortgage even faster or to build up your retirement savings.
You can choose safe investments instead, as you may still benefit from the Smith Maneuver as long as your investments do not have a negative return. This means that even if your investments end up making zero dollars, you could still be saving money from your interest tax deductions.
This depends on how much higher your HELOC rate is compared to your current mortgage rate. For example, if your HELOC rate is currently 3% and your mortgage rate is 2%, you will need to have a marginal tax rate of at least 33% to break-even if your investments were to have zero return.
Some online banks offer guaranteed investment certificates (GICs) with rates that might be higher than those offered by Canada’s major banks. For example, First Ontario’s Saven Financial offers GICs with a rate as high as 1.7% for a two-year term. This guarantees your investment from losses, which isn’t guaranteed if you invest in stocks.
The Smith Maneuver is as risky or as safe as you make it to be. Investing in GICs means that you will not be able to lose any money, however, your investment gains are also limited. If you’re worried about your GIC provider going out of business, the Canada Deposit Insurance Corporation (CDIC) insures your deposits at financial institutions for up to $100,000 each.
If you are planning on investing more than $100,000 in GICs, you can spread your GICs over multiple banks so that your entire GIC investment is insured. This safe investment approach means that you won’t be worse off by doing the Smith Maneuver if your tax deductions and GIC interest income is able to lower your HELOC rate below your current mortgage rate. Instead, you will be collecting risk-free GIC income while also being able to deduct your mortgage interest.
There is a form of risk through potential changes in interest rates. HELOCs have variable rates that change based on the prime rate. Rising HELOC rates will make the Smith Maneuver more expensive to run.
If you choose to make risky investments instead, you are putting a lot at risk. Since the Smith Maneuver results in you borrowing money to invest, you will have to pay back any money that you lose. For example, let’s say that you are halfway done paying off your mortgage. You decide to invest in risky stocks and end up losing your entire investment. Your progress in becoming mortgage-free has been completely eliminated, and you may even owe back more money than your original mortgage.